COLMA, CA - MARCH 17: Geoffrey the Giraffe is seen on the side of a Toys "R" Us truck March 17, 2005 in Colma, California. Toys R Us Inc., the second largest U.S. toy retailer, agreed to be acquired by two private equity firms and a real estate group in a deal valued at $6.6 billion after sales have sagged on competition from retailers like Wal-Mart . (Photo by Justin Sullivan/Getty Images)

Despite its Bankruptcy Filing, Toys ‘R’ Us is Not Likely to Disappear, Experts Say

In announcing the Chapter 11 filing, the retailer’s executives said in a statement that the move will not affect the company’s approximately 1,600 Toys ‘R’ Us and Babies ‘R’ Us stores located around the world, of which most are profitable.

While Toys ‘R’ Us’ bankruptcy filing came as no surprise to most retail industry experts, its implications appear to follow along two trains of thought: it serves as yet another reminder of the struggles of big-box retailers, or, it represents another chance for the retail real estate industry to innovate and come out stronger.

Toys ‘R’ Us’ stores tend to be located in large power centers with other big-box tenants which might be already struggling, says Howard Davidowitz, chairman of Davidowitz & Associates Inc., a national retail consulting and investment banking firm headquartered in New York City. “This is bad news for power centers, and it’s continuing bad news for retail,” Davidowitz says.

In announcing the Chapter 11 filing, the retailer’s executives said in a statement that the move will not affect the company’s approximately 1,600 Toys ‘R’ Us and Babies ‘R’ Us stores located around the world, of which most are profitable. Still, should Toys ‘R’ Us close its stores, it could affect foot traffic at the centers where it’s currently located and put a greater burden on landlords to find tenants who would be able to fill the large spaces Toys ‘R’ Us stores tend to occupy, Davidowitz says. “It’s a very difficult situation,” he notes.

However, it may not be as dire as it seems, at least according to Matthew Harding, president of Levin Management Corp. More than 90 percent of the North Plainfield, N.J.-based real estate firm’s portfolio comprises retail entities, and the company has four Toys ‘R’ Us-anchored properties.

As the retailer says it plans to keep its stores open, it’s business as usual, Harding says. Retailers that have filed for bankruptcy in the past have, in some cases, emerged stronger, he notes. “Bankruptcies aren’t a death knell,” Harding says.

This year saw the highest number of big retailers declaring bankruptcy since the recession, and 22 retailers and apparel companies are currently rated as distressed by Moody’s, Bloomberg reports. So far this year, major U.S. retailers have announced 6,098 store closures, which is up 182 percent year-over-year, according to research firm Fung Global Retail & Technology most recent retail tracker. However, the tracker also noted that there have been 3,381 announced store openings, which so far is up 58 percent year-over-year.

Many of Toys ‘R’ Us stores have been in their locations for some time, Harding notes, and the properties are generally located in quality centers. Even if some of the toy stores close, the leasing market is “pretty strong,” Harding says. When a tenant has been in a location for a long time—say 10 or 15 years—often it pays below-market rent, he notes. “We are in a pretty good market now in terms of tenant interest looking for additional space,” Harding adds.

As for neighboring retailers in those centers—there may be an upside should some stores shutter. Toys ‘R’ Us’ foot traffic tends to peak around the holiday season, but other large retailers—say, a TJ Maxx—that can fill a space occupied by a Toys ‘R’ Us may bring a more consistent stream of shoppers to a center, Harding says. “There’s good interest from retailers in that size range, or division of a Toys ‘R’ Us store,” he adds.

Still, the timing for the filing—right before the popular holiday shopping season—is “terrible,” says Davidowitz, noting that the holidays are Toys ‘R’ Us’ busiest time of year. However, Davidowitz notes that the retailer’s suppliers were cutting it off, meaning it had to file for bankruptcy protection so it could buy merchandise and get through the season.

Dave Brandon, Toys ‘R’ Us chairman and CEO, said in the statement that the filing allows the company to restructure its $5 billion long-term debt so it can invest in its business and strengthen its position in the competitive retail marketplace. Toys ‘R’ Us has also received more than $3 billion in debtor-in-possession financing from a variety of lenders, including JP Morgan.

Of the retailer’s debt, $444 million is due next year. Much of its debt stems from its $6.6 billion leveraged buyout by Bain Capital, Vornado Realty Trust and KKR Group in 2005, according to a report on the bankruptcy from Fung Global Retail & Technology. The retailer’s annual interest payments, during some years, was half a billion dollars, the report notes.

Morningstar Credit Ratings, in a report released before the filing, noted that around $3.6 billion in CMBS debt could be affected by this filing. However, Morningstar researchers note that overall the risk of default would likely be low. Many of the collateral properties are located in strong markets and the loans were conservatively underwritten. Morningstar found 11 properties—with about $327 million in loans—that pose the most risk of closing as their leases are set to expire before the end of 2018.

A Moody’s analyst also agrees there is little risk to CMBS debt it has tracked: “There are 98 loans with exposure to Toys “R” Us or Babies “R” Us stores across 85 Moody’s-rated CMBS deals. These loans represent less than 1 percent of the CMBS universe we rate,” says Moody’s analyst Paul Cognetti in a statement. “Given the relatively small exposure, this development is expected to have a limited impact to Moody’s-rated CMBS transactions.”

Much of the retailer’s financial woes come from its heavy debt load, which prevented it from playing the price game with some of its competitors and investing more in online technology and interactive store environments, according to Davidowitz: “They didn’t have the money. They were busy paying interest on all the debt,” he says.

Meanwhile, almost all large retailers are re-thinking their real estate, says Anne Brouwer, senior partner at McMillan Doolitte, a retail consulting firm. This could refer, for example, to whether store locations are all still productive or are the right size.

Brick-and-mortar retail will never go away, and a majority of consumer still prefer to shop in-person, Brouwer says. A key to tackling the challenges facing both retailers and landlords will be to find creative solutions to attract shoppers, Brouwer says. Both need to pay attention to basic operating excellence, such as making sure that facilities are clean, signage is clear and the atmosphere is inviting, she adds. “If it’s not innovating, if it’s not refreshing, if it’s not moving forward—it’s not a good sign.” Brouwer notes.

Davidowitz has no doubt that Toys ‘R’ Us will emerge from bankruptcy, but he questions what the company will look like in the future. “It will be a shadow of its former self,” he says. “It will have less debt, it will have less market share and it will be weakened tremendously. But it will come out.”